Fair Value Accounting — It Is What It Is

I’ve written on mark-to-market accounting before.  Searching my blog, I was surprised to find how many pieces I have written in 2008 on the topic.

So, it’s interesting to me to see the FASB interested in continuing with Fair Value accounting, despite all of the criticism.  It’s not to say that MTM accounting is perfect — all accounting methods are approximations and are imperfect, but does it convey the best information needed for investors to make  reasonable decisions, at an acceptable cost?

If MTM accounting were proposed in the ’80s it would never have been approved.  The value of common financial instruments did not usually change much; unless an equity had a public market, revaluations occurred only for reasons of impairment.  But derivatives and structured security prices vary considerably, and their prices often vary in a way that approximate valuations can be calculated from the prices of other publicly traded securities.

Now, that many financial companies trade below their net worth is a proof in this environment that investors don’t trust the value of the assets, nor their earning power.   Many assets have not been marked down to their fair value.

I will defend SFAS 157, and the other mark-to-market accounting standards, but I won’t defend an application of them that is too rigid.  When trades are infrequent, and there are strong reasons why the security deserves a different value than last trade, then let the security be marked to model.  It is the best that can be done.  But merely that a security is at an unrealized loss for several years should not in itself be a reason to mark the security down, if the management concluded that it was “money good.” (they get their principal back.)

The mark-to-market rules as stated have flexibility in them, aiming for a fair statement of the net worth of the firm.  Given the nature of the investments and hedges employed, this is a good thing if done properly and fairly.

Can these rules be used to distort accounting?  Of course, in the short run.  In the intermediate-term, the errors catch up, and destroy the cheater.  In the long run, cash flows determine the value of a business.

So, be wary in the present environment.  Just because a financial institution trades below book value does not mean that it is cheap.  Much of the cheapness stems from the opaqueness in pricing of unique risks.

The challenge is analyzing what an asset is truly worth, and when that value can be realized.  That is the challenge with financials today.

10 Comments

  • sam mogawe says:

    Well, in the case of DFR the value is clearly known: ZERO.

    Any other recommendations ?

  • Paul in Kansas City says:

    That’s comes across as a cheap shot; DFR was always discussed in the context of diversification (40 positions I believe). David is one of the few professionals who has no problem “owning up” to mistakes; it is up to each individual to do their pwn due diligence.

  • Thanks, Paul. I owned up on DFR twice in the last year — when I sold it, and in my ten worst investment decisions piece.

  • Paul in Kansas City says:

    no problem david. To become a “great investor” asmost ofus who peruse blogs such a syours you have to learn to think independently; that said it helps looking through ideas from more expereicned pros such as yourself. That never diminishes the responsibility that doing your own due diligence requires. A small step on the path of competence is taking responsibility for your own decisions and I’m grateful that you have willing shared your insights and experiences. That said it’s no fun being wrong; but in the investment profession the vanity of perfection has to be put aside!

  • Paul in Kansas City says:

    As an additional note Cramer and other columnists on Real Money (where david may periodically post and his archives are available to view) you will find competent people willing to put their ideas in print KNOWING that it opens them to criticism fromthe general public and perhaps peers. I’ve had the chance to correspond with david and Cramer for years and you will not find many as generous as they have been with their time and energy. The stresses of this industry are significant and it is amazing really the willingness of David, Cramer,and others to open themselves to endless “monday morning quarterbacking”. It’s really not worth it on a personal level but they do it anyway! Check out David’s blog link “A Dash of Insight” by Jeff Miller and take the economics challenge; it will humble any critic. To succeed humility regarding what you don’t now is a must.

    Long but not nearly enough it seems humility lol!!

  • sam mogawe says:

    New Finance equation:

    “humility” = I lost a lot of money . . .

    sam cheapshot

  • I lost a lot of money too. My sympathies — it is why I don’t like writing about individual stock ideas. Little praise when things go right, and legitimate complaints when things go wrong. It’s like being short a put option.

  • sam mogawe says:

    I suppose you are right. You got it . . .

  • Paul in Kansas City says:

    The point of the cheapshot observation is most people need to get past that to improve. Is there anyone that hasn’t made bad mistakes?? Of course not.

  • Jon in SRQ says:

    SFAS 157 & 159 “Fair Value” accounting increases the volume of disclosures, creates phantom income and phantom losses (income & losses not recognized by the IRS) and makes future income and loss predictions virtually impossible. Few public companies have benefited, many firms have seen capital depleted and equity diluted.

    The 12-20/21-08 WSJ has an article with 12 banks whose ratings were recently lowered. Watch their future financial reports since SFAS 157 turns the lower credit ratings into phantom income – probably in the billions. (Also see the 10-21-08 Heard on the Street article about billion-dollar income at two financial institutions due to MTM of liabilities.)

    A Nov 15/16 2008 WSJ article shows that under GAAP rules in use 9-30-08, Fannie had a little equity and Freddie needed another $13.8 Billion. The WSJ chart also shows that under “Fair-value Equity” method (mandatory as of 11-15-08), each had negative equity of over $40 billion. So, MTM creates over $70B of additional losses, and if future markets swing back the other way the $70B could reappear as phantom income. Unfortunately, by then the Fannie and Freddie investors will be wiped out or severely diluted.

    Look at this a different way. What securities are safe for public financial institutions to purchase? How can the public institutions avoid wild MTM price swings? Well, it would seem that they could buy treasuries and conforming mortgages and little else. IMO the only firms that can afford to buy municipals, CDOs, CMOs etc are foreign entities or private US firms that do not have the SEC’s MTM requirement. (Think of the Lehman assets that went to Barclays and the Merrill mortgage assets sold to a TX hedge fund and the current offer for IndyMac, etc.) Private and foreign firms can benefit.

    FASB has announced that they want to expand MTM. (I thought SFAS 157 said all assets and liabilities, but I could be wrong.) So the question is, how does one predict earnings or losses or book value for public US companies? It would seem that you have to get past the end of the reporting period so that you know the market prices that you are marking to. Once you have market prices to mark to, you figure actual earnings, add in phantom income and deduct phantom losses. For some US corporations the changes could be minor. Many public financial institutions have recently come close to violating their capital requirements and phantom losses could necessitate the need for more capital.

    Think of this – given the wild swings of MTM pricing, would you rather own part of a public bank or part of a private hedge fund that invests in financial assets purchased at distressed prices? The IRS used to recognize an illiquidity discount for private securities. Now that might be overshadowed by a private security premium for avoiding MTM. The playing field has changed and the US public companies are the losers. Thank you FASB and SEC.